Consultation Process Cost of Equity: BK

Transcription

1 Bundesnetzagentur Beschlusskammer 4 Stichwort Zinssatz Strom Postfach Bonn Per zinssatzstrom@bnetza.de 5 August 2016 Dear Beschlusskammer 4, Dear Mr. Lüdtke-Handjery, Dear Mr. Lamoratta, Consultation Process Cost of Equity: BK We are pleased to submit IFM Investors position as part of the Bundesnetzagentur s consultation process regarding the recently proposed cost of equity for gas and electricity network companies of 6.91% pre-tax for new assets and 5.12% pre-tax for old assets applicable for the third regulatory period (gas: and electricity: ). IFM Investors is one of the largest managers of infrastructure funds with over 20 billion of infrastructure equity investments worldwide, including an investment in 50Hertz Transmission GmbH ( 50Hertz ). In addition to 50Hertz, IFM has regulated investments in the UK, Poland and the USA. This gives us a unique insight into different regulatory frameworks and how regulators set the appropriate cost of capital in different countries and a variety of sectors. We are also continually reviewing new investment opportunities on a worldwide basis and achieving an appropriate risk adjusted rate of return is a fundamental aspect of our investment decision. Since our investment in 50Hertz in 2010, we have observed overall a positive development of the German regulatory framework, which has evolved closer to international standards through a number of improvements being made. This progress has supported the implementation of the Energiewende, an ambitious energy policy that requires the long term commitment of all participants in the electricity system. In this context, we consider the cost of equity a key parameter of the German regulatory framework. Having reviewed the proposed cost of equity for the next regulatory period and analysed the studies underpinning this proposal, we believe that the proposed rates do not properly incentivise the large capital requirements and do not address the specific risks of the German gas and electricity transmission sectors. We have also identified some inconsistencies in the determination of certain input parameters that are used to calculate the cost of equity. 3 rd Floor 60 Gresham Street London EC2V 7BB United Kingdom ifminvestors.com 1 Company No , FSA Licence No IFM Global Infrastructure (UK) GP Limited Company No

2 Our view on the proposed cost of equity is based on the following: 1. The large capital requirements and the high complexity of the investment projects needed to implement the Energiewende, especially in the electricity transmission sector, which reinforces the need to set the cost of equity at a competitive level that will attract German and international capital to the sector; 2. There are a number of inconsistencies in the application of the CAPM methodology used to calculate the cost of equity; 3. Germany s electricity system benefits from the commitment of a long term investor base that needs stability in the regulatory parameters to support the network s development given the long time horizon of these investments; and 4. When benchmarked against other recent international regulatory decisions, the proposed cost of equity is one of the lowest allowed returns set by any regulator worldwide. Each of these elements is described further below: 1. Need for significant capital to fund large and complex development plan In order for Germany to meet its ambitious renewable energy targets through the implementation of the Energiewende, the country will require significant capital investments of over 50 billion over the next decade in the electricity transmission sector alone, according to the grid development plans for the year This unprecedented capital need will be competing with capital requirements elsewhere in Europe and from around the world in the infrastructure space. In addition to the large capital requirements in the developed world due to aging infrastructure and the need for transformative infrastructure investment, there is a rapidly growing investment boom in the developing world that will require substantial capital investment. In this context, the development needs of the German electricity system present a specific characteristic: the high volumes and technical complexity of the projects included in the Network Development Plan. Initiatives such as offshore connections via deep-water cabling, voltage capacity increases of operating lines and the construction of cross-border phase-shifters add a layer of additional risk and complexity to the investments in the network that should be adequately addressed in the cost of equity assessment. In addition, the regulatory cost of equity should not be considered in isolation as it incentivises the network developments that allow the German electricity system, and therefore the end consumers, to minimise re-dispatch expenses and other inefficiencies, which are growing as a result of the changes happening due to the Energiewende. 1 Netzentwicklungsplan Strom and Offshore Netzentwicklungsplan available on: 2

3 According to 50Hertz calculations, based on published data for capital costs of electricity grid operators in Germany, an increase in the cost of equity of 100 basis points generates additional capital costs of 160 million per year. This amounts to an increase of the annual end-consumer electricity cost of just 3. On the other hand, system costs such as the re-dispatch measures, which alone totalled approximately 1.1 billion in 2015, could be materially reduced through capital investment increasing the network s capacity. In summary, we believe that, in a world of growing competition for capital, Germany will need competitive returns to be able to attract significant new capital to meet its large and complex capital requirements, and to improve the system s operations and efficiencies and lower the overall cost to the end-consumer. 2. Inconsistencies in the application of the CAPM methodology While we support the use of the Capital Asset Pricing Model ( CAPM ) methodology in determining the cost of equity, after reviewing in detail the elements of the CAPM calculation as outlined in the report by Frontier Economics and the Draft Decision BK , we have identified the following inconsistencies in the determination of the Market Risk Premium and the beta: Market Risk Premium The reduction in the Market Risk Premium from 4.55% in the October 2011 decision to 3.80% in the draft decision of July 2016 is not consistent with the broader market evidence, which indicates otherwise: the Deutsche Bundesbank has observed that due to the high levels of volatility in the global financial markets and ongoing macroeconomic uncertainties, decreasing risk free rates have been offset by increasing Market Risk Premia in Germany leading to a relatively stable total return target of c.8% post-tax 2. Furthermore, this is consistent with the fact that no European regulator has to date decreased simultaneously both the risk free rate and the Market Risk Premium in its regulatory return calculation 3. This evidence contradicts the statement from Frontier Economics referring to declining premia. The decline in Market Risk Premium proposed by Frontier Economics is largely driven by the introduction of Russia and China into the sample of market performances over the past 115 years. The fact that these two countries have been communist regimes without free market economies nor perceived true functioning stock markets over the vast majority of the observed timeframe means that the observed market premium returns in those jurisdictions lack the transparency and efficiency of free capital markets. This argument is supported by the approach used in the telecommunication sector. The consultant engaged by the Bundesnetzagentur for the telecommunication sector, Professor Stehle, excludes the countries China and Russia since these countries do not represent well developed capital markets. The telecom Market Risk Premiumonly consists of proved capital market data for developed markets (USA, GB and Germany) to avoid distortions by 2 Eg, April 2016 Research Report from the Deutsche Bundesbank, p l Nera Report for BDEW Stellungnahme zu den Beschlussentwürfen BK und BK der Bundesnetzagentur, p.15. 3

4 unrepresentative markets 4. We therefore strongly believe Russia and China should be excluded from the sample and we do not follow nor agree with Frontier Economics rationale to change the approach from that used in the 2011 determination. The draft decision gives inappropriate weight to geometric averages when calculating the Market Risk Premium. It is well established in financial economics that the arithmetic mean is the appropriate forward-looking measure of Market Risk Premium. Geometric averages merely provide a measure of past performance and do not capture the uncertainty of stock prices going forward. Ian Cooper, a leading academic in this field, sums up the academic discussion by stating that the arithmetic historical mean is the single statistic that is favoured by many experts. 5 Moreover, there is evidence of regulators in other European countries such as Luxembourg, France, Italy and Austria recently adapting their methodology by increasing the weight of the arithmetic mean in their calculation 6. Calculation of Beta Frontier Economics peer short list is not consistent over time as since 2011 it has introduced Elia System Operator, Spark Infrastructure, Duet Group and Redes Energeticas Nacionais, although none of these utilities has changed its business nature since The list is not consistent by definition as it still excludes regulated utilities such as Belgium s Fluxys. Being consistent and using the 2011 Frontier Economics peer short list, the 1-year average asset beta would be 0.48, which is materially higher than the currently proposed 1- year 0.43 and is a more consistent and appropriate approach. Frontier Economics calculation of beta as an average of non-german utilities does not factor in Germany s specific risk related to large investment volumes and high complexity projects of the German electricity transmission system. Low betas such as Redes Energeticas Nacionais 0.20 reflect the low risk of the limited capex plan of that company. For this reason, we believe that Frontier Economics peer shortlist should be reviewed to properly reflect the specificities of the German electricity transmission market and regulation. The formula to de- and re-lever betas in the draft decision is based on Modigliani-Miller and thus is not consistent with standard practice in finance. Standard practice assumes that tax shields have the same risk as the operating assets and requires the use of the Miller formula. 7 The Modigliani-Miller formula leads to an unreasonably lower cost of equity than the Miller formula. For instance, regulators from European countries such as Switzerland and Norway use the Miller formula. 4 Stehle (2016): Wissenschaftliches Gutachten zur Schätzung der Marktrisikoprämie (Equity risk premium) im Rahmen der Entgeltregulierung, Seite Cooper, I. (2004) The Equity Market Premium: Comments on the Ofcom consultation document, Ofcom s approach to risk in the assessment of the cost of capital, p Nera Report for BDEW Stellungnahme zu den Beschlussentwürfen BK und BK der Bundesnetzagentur, p.15, p See e.g. the Practitioner s Guide to Valuation from Koller, Goedhart, Wessels (2005), p

5 Finally, we believe that the proposed cost of equity does not fully reflect the true long term cost of equity due to the unusual economic and financial conditions that currently exist. The extraordinary monetary easing from the European Central Bank ( ECB ) has substantially influenced and distorted the markets, depressing risk free rates and pushing a substantial portion of the German outstanding Bunds into negative yield territory. In the assessment of the cost of equity, these short term and extraordinary circumstances which have been implemented to artificially influence the markets should not outweigh the long term nature of the capital investments in the electricity network. In this context, we believe that it would be consistent to introduce a CAPM premium that properly reflects the current extraordinary financial circumstances. It should be noted that this measure has already been taken by other European electricity regulators such as Belgium s VREG, which used a so called ECB premium in the latest return calculation. 3. Stability of the German regulatory parameters The German electricity system currently benefits from the commitment of long term investors that support the network s development. Their long term investment horizon allows these investors to support large capital expenditure plans that will be recovered over an extended period of time. These investors are focused on sustainable and sufficiently resourced assets that can deliver efficient and high quality services not only to consumers today, but also for future generations. Long term investors, such as IFM Investors, manage the retirement savings of millions of workers and pensioners worldwide and have the obligation to carefully scrutinise their investments in order to secure the pensions of their clients. Investors of this nature require stability in the regulatory parameters. In this context, a sharp decrease in the regulatory cost of equity for new assets from the current 9.05% to the proposed 6.91% for the next regulatory period, representing a c. 24% decline, combined with the inconsistency in the application of the cost of equity calculation methodology from the previous regulatory period (see section 2 above), would negatively impact the perceived stability of the German regulatory parameters, thus not be supportive of the long term commitment that such long term capital investments require. This is especially important with respect to implementing the Energiewende in a fashion that minimises the cost to the endconsumer. 4. International benchmarks of allowed cost of equity The proposed cost of equity is significantly below that set by other regulators and is therefore less competitive. The chart below shows a like for like comparison of the cost of equity of regulated electricity and gas sectors in Europe: 5

6 10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% 5.81% 7.93% 6.77% 6.45% 6.74% 9.08% 7.96% 6.96% 7.64% 10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% European post-tax CoE benchmark CoE of 5.64% (proposed 6.91% adjusted for corporate tax) As shown above, the proposed post-tax cost of equity of 5.64% (the proposed 6.91% adjusted for corporate tax) is below the international benchmark range of 5.81 % to 9.08 %. In addition to the four points discussed above, it is important to emphasise that, as in any regulatory framework, the cost of equity cannot be seen in isolation - what is critical from the point of view of investors is the actual return on equity. This in part depends on the performance of the regulated utility, which is in the control of the individual companies, but also on the other aspects of the regulatory framework. In fact, the German regulatory system has features which prevent companies from fully achieving the allowed return on equity. Major issues include the wrongly imputed tax calculation that leads to a reduction of return, the t-2 delay in cost recovery, investment measure limitations, the HGB accounting treatment of regulatory assets, and insufficient recognition of personnel costs. Despite the recent improvements in the regulatory framework, these deficiencies still exist, which prevents even well managed and efficient companies from earning the allowed return on equity. In summary, we believe that the proposed cost of equity should be revised upwards to properly incentivise the large capital requirements of the German electricity system to implement Energiewende and minimise the cost to the end-consumer. This would also reflect the risk associated with the long term nature and technical complexity of the network development projects, provide consistency to the calculation methodology, confer stability to the regulatory parameters, and achieve international benchmark levels. We look forward to the Bundesnetzagentur s response to the consultation process and we would be happy to answer any questions that you may have on the contents of this letter. Yours sincerely Christian Seymour Lars Bespolka Head of Infrastructure Europe Executive Director 6